Companies that take payroll for granted may end up spending too much, alienating employees, even getting hit with hefty fines or lawsuits. While there are a lot of moving pieces—timekeeping, releasing funds to your financial institution, remitting taxes, managing benefits and other deductions—companies with formalized processes in place will find it easier and more cost-effective to pay workers properly and on time.
What Is Payroll?
The word “payroll” can mean several things, all related to employees and their pay. This article will focus on the processes involved in paying employees for their work. These payroll-related tasks include tracking hours, calculating wages, paying and withholding taxes, managing deductions and benefit contributions, and then getting accurate checks or direct deposits to employees on time.
In midsize and large companies, responsibility for payroll typically belongs to the finance or human resources department. In smaller firms, an accountant or even the owner may be in charge of the process. Regardless of company size, payroll can be challenging because salaries, tax withholding and benefit profiles must be individualized for each staff member. In addition, the company must accurately withhold income and other taxes from each check and pay it to the relevant local, state or federal government.
- Payroll is one of the most important aspects of running a business. It’s also one of a company’s largest expenses.
- Errors in payments, whether to employees or the government, can have costly consequences. Software can help automate the process.
- Payroll responsibilities involve more than issuing paychecks. They include withholding income and other taxes, deducting for employee benefits and issuing payments on time.
The employee payroll process typically starts when a new hire fills out a W-4 form, which determines how much tax will be withheld. Then, for each pay period, the company calculates how much is owed to each employee—a complicated process because tax withholding and other deductions, such as benefits, may be different for each worker.
The company then determines if it’s eligible for any payroll tax credits and remits the withheld employee taxes to federal, state and local authorities as appropriate, along with the employer’s share of taxes, and issues a check or direct deposit for the amount due the worker.
How Does Payroll Work?
If you pay employees, you need a process to manage payroll. What does that entail? The details vary, but essentially, an implementation plan consists of three main stages: The company gathers information from each employee, calculates pay and deductions each period, and files and pays the worker and governments as required.
Step 1: Gather information.
The company collects a W-4 form for employees or a W-9 form for independent contractors as well as state withholding certificates as required, a Form I-9 (to verify employment eligibility), bank information (for direct deposit), and any forms related for medical insurance and retirement benefits. Every company with employees also needs to apply for a federal Employer Identification Number (EIN), which can be obtained online from the IRS.
Step 2: Pay employees.
For each pay period, the company calculates each employee’s gross wages and deductions, such as tax withholding, health insurance and/or retirement plan contributions. The result, net pay, is then delivered to an employee on payday, either electronically or by check.
Step 3: Remit payroll taxes.
The business pays the withheld employee taxes as well as its own share of payroll taxes to the IRS and appropriate local authorities. It also keeps records in compliance with IRS and Department of Labor rules, and reports taxes per federal, state and local requirements.
Businesses can choose how often they pay employees. Options include weekly, biweekly, semi-monthly and monthly. Some states set a minimum permitted frequency; you can find payday requirements for each state on the Department of Labor website. If employees work in different states, an employer will need to align with the relevant state law for each employee.
Paying semi-monthly—that is, twice a month on a fixed date—may be more difficult to administer because each pay period has a different number of days. From an employee standpoint, being paid less frequently, such as monthly, can cause cash-flow problems.
The costs of paying weekly can quickly add up; payroll costs include fees paid to software or service providers, banking charges for direct deposits and any mailing costs.
For businesses, biweekly is often the sweet spot. It’s the most cost-effective and simplest option and also the most common pay period frequency, according to the U.S. Bureau of Labor Statistics.
5 Employer Payroll Responsibilities
Employers are generally responsible for ensuring that payroll calculations are correct and that employees are paid in a timely way. This includes accurately calculating tax withholding and benefit contributions, and filing and paying federal, state and local taxes. Here are five key employer responsibilities:
- Accurately calculate taxes. Employers must calculate their share of federal and any applicable state and local taxes. In addition, they must account for Federal Insurance Contributions Act (FICA) taxes, which pay for Social Security and Medicare and Federal Unemployment Tax Act (FUTA) taxes, which fund unemployment benefits. Employers are responsible for calculating and withholding employee income taxes based on the employee’s W-4 and state withholding forms.
- Deduct employment tax. Each pay period, employers are required to deduct tax and any voluntary deductions from employees’ wages.
- Deposit employee and employer taxes using the Electronic Federal Tax Payment System (EFTPS). Employers need to enroll in EFTPS, a system set up so taxpayers can make tax payments and deposit withholdings promptly. Otherwise, an employer could face significant penalties.
- Keep payroll records. This should include worked hours, wages, tax expenditures and receipts of the funds used to pay the taxes.
- Provide employees with payment summaries. This includes the annual rundown of earnings and taxes that workers need to file their own tax returns.
IRS Employment Tax Documents Checklist
|IRS Employment Tax Documents Checklist|
|Your EIN||Names, addresses, SSNs and occupations of employees and payment recipients|
|Amounts and dates of all wage, annuity and pension payments||Any employee copies of W-2 and W-2c forms returned to you as undeliverable|
|Amounts of tips reported to you by your employees who receive tips||Dates of employment for each employee|
|Records of fringe benefits and expense reimbursements provided to your employees, including T&E records/receipts||Periods for which employees and recipients were paid while absent due to sickness or injury and the amount and weekly rate of payments you or third-party payers made to them|
|The fair market value of in-kind wages, such as goods or services in lieu of cash||Copies of returns filed and confirmation numbers.|
|Copies of employees' and recipients' income tax withholding certificates (Forms W-4, W-4P, W-4(SP), W-4S, and W-4V)||Dates and amounts of tax deposits you made and acknowledgment numbers for deposits made by EFTPS|
|Records of allocated tips, that is, additional tips you pay to an employee|
Ways to Process Payroll
Businesses have several options to run payroll. Small companies often start by managing payroll manually. But as they grow and that task takes correspondingly more time, it generally makes more financial sense to automate the process using payroll software or an outsourced service. Automating payroll can cut the time and effort required and reduce errors.
Let’s look at the three main options.
- In-house, manual: Companies calculate employees’ pay using spreadsheets and/or online payroll calculators, which determine tax withholding and other deductions. This process can easily become complex given that employees have different salaries and tax withholding preferences. This approach is also vulnerable to human error, mainly because of its complexity. A staff member must closely track changes to tax and labor regulations to ensure employees’ pay is correctly calculated. Manually running payroll is also the slowest and most labor-intensive method, partly because of the paper trail that must be maintained to protect a company in the event of an audit.
- Outsource: Businesses can hire an external payroll company or an accountant to handle payroll. Outsourcing often means a hands-off process for a business after the initial payroll setup, although certain information, such as employee time cards, must be provided if the payroll company doesn’t offer a time-tracking app or another way to track hours. The provider handles all payroll calculations and distributes paychecks. The outsourcing provider is also responsible for compliance with tax and labor laws, so an employer is not held liable for penalties if paychecks or tax filings are incorrect.
- Software: Software solutions provide freedom from some of the more grueling aspects of running payroll while allowing an employer to retain control over the process. A good payroll software solution stays current with legal requirements in every jurisdiction and saves customers time by performing tasks such as automated calculation of earnings and deductions, real-time payroll review and editing, payroll tax filings, and distribution of end-of-year tax forms.
7 Steps for Processing Payroll
Once you’ve collected the required documents, set a payroll cadence and determined how you’ll manage the process, there are seven steps to processing payroll.
- Record employee hours. This can be done manually, using punch cards or with time-tracking software. Accuracy is key here.
- Calculate gross pay. For employees who are paid based on an hourly wage, add the number of hours worked in a given pay period and multiply by their hourly rates. Note that overtime hours generally must be paid at time-and-a-half. For salaried employees, gross pay is calculated as the year’s salary divided by the number of pay periods.
- Determine each employee’s deductions. Attention to detail is required here because states have different requirements. Deductions include payroll taxes: federal taxes, Medicare and Social Security (FICA) and unemployment (FUTA). In addition, employees may pay state and local taxes, and some opt to participate in 401(k) plans. Employees may also contribute to health insurance and retirement plans, with a mix of before- and after-tax deductions.
- Figure out net pay and pay employees. Subtract all deductions from each employee’s gross pay to obtain net pay. Pay employees via direct deposit, check or pay card. Also, be sure employees are able to easily access a copy of their pay stubs.
- Pay payroll taxes. All federal tax deposits—income tax, FICA and FUTA—must be made via EFTPS. Businesses that reported $50,000 or less in tax liability for the previous four quarters can deposit taxes monthly; those reporting more than $50,000 in taxes for the previous four quarters must deposit semi-weekly (twice per month) based on the day you pay employees.
- Record each paycheck. Thorough, accurate record-keeping is a must, as mandated by the Fair Labor Standards Act. Businesses must be able to supply payroll records within 72 hours to the Department of Labor upon request.
- Update General Ledger Accounts. Since payroll is one of the largest expenses for a company, it’s important to update your general ledger accounts after each pay period to keep financial reports accurate and up-to-date.
Essential Payroll Components
Whether you pay employees manually or by using an outsourcing service or software, you’ll need to create a system for managing payroll. For example, you generally need a point person within the company who’s responsible for payroll, and you need to define payroll policies and communicate them to employees.
Typical components of a company’s payroll system include:
- A payroll manager. A dedicated point of contact can help payroll run smoothly. The payroll manager is responsible for issuing paychecks and/or electronic transfers to bank accounts; summarizing earnings, taxes, deductions, leave, disability and nontaxable wages; and balancing payroll accounts.
- Payroll policy. The policy should include information on paycheck frequency, timesheet submission, over/underpayments, mandatory deductions and benefits. This helps to set expectations for employees and resolve problems.
- Payroll processing method. You’ll need to decide whether to run payroll manually or use software or an outsourcing service and figure out other day-to day aspects of payroll processing, such as how you’ll track employee time.
- Payroll register. A payroll register is an accounting summary of employee earnings and deductions for each pay period. It includes hours worked, gross pay, net pay, deductions and payroll date. It maintains a record of payroll expenses and helps the company analyze costs.
How Is Payroll Calculated?
An employee’s pay is calculated each pay period in a series of steps that start by calculating gross pay and end up with the amount employees see in their paychecks.
- Determine an employee’s gross pay. Multiply their hourly rate by the total hours worked in the pay period, plus overtime. For salaried workers, gross pay for each pay period is calculated by dividing yearly salary by the number of pay periods in a year. If someone earns an annual salary of $104,000 and is paid weekly, the gross pay for each pay period is $2,000 ($104,000 / 52 = $2,000).
- Figure federal income taxes. Employees are taxed individually at rates based on their incomes and withholding allowances.
- Calculate FICA taxes. Multiply each employee’s gross pay for the pay period by 6.2%, which is the worker’s portion of the Social Security tax liability, to calculate their contribution. In the example above, the employee would pay $124 per paycheck for Social Security taxes ($2,000 x .062 = $124).
- Compute any applicable state or local taxes. Payroll tax laws and tax rates differ from state to state, so verify with relevant state and local government agencies to accurately determine necessary taxes. If some employees went from working in an office to working from home, potentially in a different state from your headquarters, those remote workers could create an economic nexus—and unanticipated filing responsibilities for the business.
- Calculate other deductions. Calculate voluntary deductions, such as contributions to retirement funds and medical insurance, plus any involuntary deductions, such as court-ordered garnishment of wages.
FICA taxes = Gross pay for pay period * 6.2%
Note that the Social Security tax liability is based on a taxable wage base of $137,700; employees who make more than that are taxed for only the first $137,000 earned annually. In addition, FICA taxes are a shared liability between employer and employee. That means an employer has to match the amount an employee remits to the government.
For the Medicare portion of FICA, multiply the employee’s gross pay for the pay period by 1.45%, which is their portion of the Medicare tax liability. In our example, the employee’s Medicare tax liability for each weekly pay period is $29 ($2,000 x .0145 = $29).
Medicare tax = Gross pay for pay period * 1.45%
The total FICA contribution is the sum of Social Security and Medicare, or $153 in our example.
Subtracting the amounts calculated in these steps yields the employee’s net pay, also referred to as take-home pay.
A deduction is an amount subtracted from an employee’s gross pay, thereby reducing net pay. Deductions can be mandatory, such as taxes, or voluntary, such as retirement contributions.
The five mandatory payroll deductions are:
- Federal income tax withholding: The IRS provides tables for determining withholding amounts in publication 15.
- State income taxes for the states that impose these taxes.
- Local taxes, such as city, county or school district taxes.
- Social Security tax withholding of 6.2% on wages up to the annual maximum taxable earnings of $137,700 for 2020 and $142,800 for 2021.
- Medicare tax withholding of 1.45%, plus an additional Medicare tax withholding of 0.9% for employees earning more than $200,000.
If relevant, court-ordered garnishments, such as child support payments, are also compulsory. Voluntary deductions include contributions to retirement accounts, such as 401(k) accounts or IRAs as well as life insurance and insurance premiums.
Payroll taxes are paid by both employers and employees. Each pay period, employers must withhold money from workers’ paychecks to cover employee contributions to income taxes as well as Social Security and Medicare taxes (FICA). The employer is also responsible for paying some payroll taxes, including FUTA and the employer’s share of FICA taxes.
The amount of federal income tax withheld is determined by IRS form W-4, which employees fill out when they start their jobs. Some states also require income tax withholding.
Only employers pay FUTA, which contributes to funds that state agencies use to pay unemployment benefits to eligible workers. In addition, employers that operate in California, Hawaii, New Jersey, New York and Rhode Island must pay disability insurance taxes.
7 Payroll Best Practices
Employees and the government expect to be paid accurately and on time. Failure to meet those responsibilities can result in significant penalties, lawsuits, low employee morale and reputational damage. Here are some ways to help ensure payroll rolls smoothly.
- Adopt up-to-date payroll management software. Payroll management software can improve payroll efficiency. By automating processes and connecting accounting and HR information, payroll solutions can save time and prevent costly mistakes.
- Check employee classifications. Incorrectly classifying employees as independent contractors can lead to fines and potentially other problems, such as employee lawsuits. Employees may be entitled to company benefits and unemployment compensation, while contractors generally are not. There are also tax liability differences; for example, you need to withhold income and FICA tax contributions for employees, but not for contractors. For employees, you also need to pay the employer’s share of FICA and other applicable taxes. So be sure you understand and comply with up-to-date classification guidelines.
- Maintain a calendar of important tax dates and deadlines. This information should be shared with the payroll team, too. Missing a deadline could result in penalties.
- Maintain a policy and procedures document. Create a payroll policy if you don’t have one, and update it at least annually if you do. Store it online where it’s accessible to workers and direct them to your policy for questions about pay periods, tax forms, deductions and personal time off. Keep downloadable copies of important forms online as well.
- Promote direct deposit. Paper checks cost money to print and mail. Encourage staff to enroll in direct deposit. This also ensures that employees’ pay is available in their bank accounts on payday and eliminates the possibility of checks being lost or stolen and the cost of putting a stop and reissuing a check.
- Keep open lines of communication with staff. Employees should feel comfortable about sharing any payroll-related problems with their employers so that possible issues can be addressed. Encouraging input in shaping payroll policies may boost employee morale.
- Distribute the payroll workload. Delegating payroll tasks, such as calculating payable hours, commissions, bonuses, taxes and deductions, among staff can help ease the load. With training, even employees outside the payroll department can take on non-core tasks, such as collecting forms during the onboarding process, thus freeing up payroll experts to focus on more time-intensive tasks. Consider adopting payroll self-service applications so employees can securely keep critical payroll information, like addresses, up to date.
How Payroll Software and Automation Can Help
Even automated payroll processing requires attention to detail. Manual processes are particularly time-consuming and prone to error. One small mistake in manual data entry—such as employee time entry, attendance and commission/bonus data—can lead to serious problems.
Investing in payroll software that can unify and automate payroll processes can help on all those fronts. Businesses can concentrate on their core competencies and focus on increasing revenue when they are assured that crucial internal processes such as payroll are being handled properly. Payroll software can improve the payroll process by:
- Streamlining tasks. Payroll can be run more quickly when it’s automated. Earnings, deductions, company contributions, taxes and paid time off can be calculated automatically.
- Reducing costs. Payroll software can be used to pay employees through direct deposit at no extra charge. Businesses also save on postage.
- Eliminating errors. Software can handle complex tax regulations, including new forms and requirements. Companies can offload all payroll tax filings and deposits confidently. Software can also take on the challenges of multi-state taxation, preparation and printing of W-2 forms, and determination of tax jurisdictions.
Payroll can be a complicated and laborious process, but it’s also one of the most important aspects of running a business. It’s critical to understand the ins and outs of payroll, from onboarding to pay periods, worker classifications and tax law. Software can help employers accurately and efficiently pay employees on time, every time, cutting down on manual work and error.